Lenders and investors look to key indicators of a business's financial health to see if the business is likely to earn a profit. The debt-to-net-worth ratio, also known as debt-to-equity ratio is one of these indicators. The debt-to-net-worth ratio is also used to evaluate the financial status of individuals.
The debt-to-net-worth ratio of a company or individual is a comparison of how much debt the entity is carrying compared to how much net worth it has. This comparison is generally expressed as a percentage but may also be expressed as a ratio. A company that has $50,000 in debt, with $100,000 in net worth has a 50 percent debt to net worth, or a 1:2 debt-to-net-worth ratio.
Begin by calculating the company's or individual's total debt. Include all long-term and short-term obligations. Subtract this amount from the total of all of the assets, including real estate and accounts receivable. The result is the net worth. Divide the total debt by the total net worth, and multiply by 100 to arrive at the percentage of debt to net worth. You can take the total of assets and liabilities directly from the balance sheet.
Banks and investors often refer to the debt-to-net-worth ratio as an indicator of overall financial health. With business, if the company has a low debt-to-net-worth ratio, most of the business is financed by investors or retained earnings. If the ratio is high, much of the business is being financed by lenders. The trend of the debt-to-net-worth ratio over time can be a better indicator of financial health. If the ratio is rising, the business may not be earning enough money to pay its expenses and borrowing money to cover its operating costs.
Banks use the debt-to-net-worth ratio to help determine the credit-worthiness of a person or company. If the ratio is low, more assets are available to secure a loan. If the ratio is dropping, it is a good indicator that the business is earning money to increase equity and reduce debt, making it a better financial risk. While investors still like to see debt low in relationship to equity, a higher debt position means that the business is using more leverage, and a smaller investment may grow more quickly, but with the same potential to fail more quickly as well.